Love , Madoff and the SEC

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Love, Madoff And The SEC
David Serchuk, 12.22.08, 06:00 AM EST
The Forbes.com Investor Team examines how regulators and firms can get too close.

How far did Bernard Madoff's alleged Ponzi scheme reach? One indication is that a fair number of Forbes.com Investor Team members know people who were involved. Michael Ervolini of Cabot Research is friends with an 80-year-old woman who went, he says, from a comfortable life to having to eke by on Social Security. Stephen Roseman of Thesis Capital says some of his investors lost Madoff money.

It stands out as one of the more astonishing aspects of the entire Madoff debacle that the Securities and Exchange Commission will now have to, in the words of outgoing Chairman Christopher Cox, investigate "all staff contact and relationships with the Madoff family and firm, and their impact, if any, on decisions by staff regarding the firm."

One obvious relationship Cox seems to be referring to is between Eric Swanson, a former assistant director at the Securities and Exchange Commission's Office of Compliance, Inspections and Examination, and Shana Madoff, a former compliance officer at Bernard L. Madoff Investment Securities, who is Madoff's niece.

Swanson and Shana Madoff met on the compliance conference circuit, at an industry group breakfast in 2003. They became romantically involved in 2006. Months later, Swanson left the SEC. The couple married in 2007. Swanson had minor involvement with SEC inquiries about Madoff's firm and he also worked on an SEC complaint against the National Stock Exchange that was settled in 2005. He is general counsel at BATS Trading, the third-largest stock exchange in the U.S. and rapidly growing.

What will come of the investigation remains to be seen. But there is a larger issue at stake here, the Forbes.com Investor Team feels. One of whether the regulatory examination process is part of the problem. At issue is whether there is potential for too much intimacy when you confine people into forced proximity for what can be weeks or even months at a time. If so, it could point to an inherent flaw to how the SEC or any other regulatory body does its on-site inspections.

Roseman, founder of Thesis Capital, notes that it's commonplace for casual relationships to arise between examiners and people at the firms they examine, even sometimes leading to job offers. "It's not uncommon for people in that role to get to become quite familiar with one another," he says.

Marc Lowlicht, president of the Wealth Management Division or Further Lane Asset Management, agreed that the potential for such over-familiarity is real. He adds, if that should happen, the potential for being unbiased in your decision-making process as an examiner disappears.


Ervolini, chief executive of Cabot Research, examines markets through the lens of behavioral science. He took the issue a step deeper. One suggestion he makes is for regulators to rotate in new staff at regular intervals in order to keep any sort of Stockholm Syndrome from developing.

Ervolini adds that another flaw with friendliness is that it makes would-be investors highly susceptible to getting fooled. This explains, in part, why so many seemingly sophisticated investors lost billions to Madoff, when he had what (so far) looks to amount to little more than a black box of a trading system.

This issue is that if we like someone we are far more likely to feed them softball questions in order to back up the decision about them we've already made. Conversely, if we don't like someone, we'll play hardball with them. What we should do, Ervolini says, is the opposite. Play tough with people you like and toss some softballs to those you are not as comfortable around.

Peter Gschweng, chief compliance officer at Firstrade Securities, agreed that the potential is there for investigators and those they investigate to get chummy. He's seen it first hand, as he had conducted exams for the National Association of Securities Dealers between 1990 and 1994. In fact, Gschweng admits, he had a brief "more than friends" relationship with a chief operating officer at one of the firms he'd examined, after the exam was finished. "If it can happen to me, it can happen to thousands of examiners out there for the Financial Industry Regulatory Authority," he says.

Still, Gschweng doubts that even if he were so inclined Swanson could have buried any incriminating evidence he'd uncovered about Madoff's firm. "One guy can't make a decision--unless he's in a senior position--to not follow through with an investigation or to sweep something under the rug," he says. "It would have to be collusion of many people to give Madoff a break."

Bob Mewshaw, chief investment officer of the small investment advisory firm Van Sant & Mewshaw, paints a much different picture of the examinations he's experienced. "They prove and ask questions, and we answer them," he says. There's no animosity, he says, but also no friendliness.

Jonathan Kord Lagemann, a longstanding securities attorney and Forbes.com Investor Team member, says that, in his experience, SEC investigators traveled in groups of three--"like nuns"--in order to escape even the suggestion of having personal relationships with a firm. "You would never be alone" with an SEC attorney, he says.

An SEC spokesman declined to comment on whether it is still commission policy to have their inspectors travel like nuns. The experiences of our Forbes.com Investor Team suggest that quaint old notion was long ago put to bed.